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Depreciation

9. Expense method depreciation and leased property (Thomann v. Comr.)

There have been several “developments tax-wise in recent years that provide farmers with a way to achieve tremendous levels of depreciation on their returns – and, actually, if they don’t have enough income to fully utilize that depreciation, to show a loss on the return that can be carried forward, or back, to other tax years.

“But as this Iowa case points out, the depreciation provisions must be used very, very carefully.”

“With respect to expense method depreciation, in particular (now available up to $500,000 for 2010/2011), it’s an off-the-top allowance for a lot of farm assets used in the farming business. There are some limits – you must have farm income and have to be in the active conduct or a trade or business. That has implications if you’re leasing property under which assets you’ll claim expense method depreciation are involved.”

In this case, “a southeast Iowa farm couple owned and operated a 504-acre farm. They orally agreed to lease 124 acres – along with buildings, grain bins and equipment – to a hog farrow-to-finish business they also owned. They annually received $70,000 in cash rent for that.”

The couple claimed expense method depreciation on a lot of those assets under the lease. Those included pick-up trucks and the like.

“They leased the balance of the farmland to an unrelated party – again, under an oral lease. On that land, they were claiming expense method depreciation on such thing as drainage tile lines and fences.

“What happens in that situation is a special rule comes into play. If you’re claiming expense method depreciation on assets that are leased, you need to establish what the term of the lease is. So, you need a lease in writing. You also need to establish you’re materially participating; or, at least, not just passively collecting cash rent income under the lease.”

When the couple was unable to do that “the court knocked them out because it was just an oral lease and they couldn’t establish what the lease terms were. They were caught by the ‘non-corporate lessor rule.’

“But they would still have been nailed, I think, on the fact that they had cash leases. They weren’t deriving income from the active conduct of a trade, or business.

“It was big case and a big point was made. (The couple) had a lot of additional taxes to pay, plus penalties.”

Does a farmer need to take such business not just to a CPA but also a lawyer?

“A well-schooled CPA in farm taxation would have caught that and it wouldn’t have been a problem. A CPA knowledgeable in farm tax is able to set that up correctly.”